Dividends paid on participating life insurance policies issued by mutual life insurance companies represent that policy’s equitable share of the company’s divisible surplus. Divisible surplus is that portion of the surplus that the board of directors designates as available to be distributed as dividends. A surplus is achieved when the actual experience is more favorable than the assumptions used to construct the policy.
Life insurance companies use very conservative assumptions when constructing a policy to ensure that it collects enough premiums to pay all contractual guarantees, even under adverse financial conditions. The premium, initial death benefit and the guaranteed cash value cannot be changed, regardless of internal or external financial conditions.
Given the conservative nature of the initial assumptions, it’s not surprising that most mutual companies can generate a surplus from year to year. The surplus comes primarily from three areas: favorable 1) investment results, 2) mortality, and 3) expenses. While some surplus is accumulated for internal purposes, some is earmarked to be distributed as dividends.
An actuarial concept known as the Contribution Principle is used to determine how the total divisible surplus is allocated to each policy. Using the Contribution Principle, actuaries first estimate the portion of surplus that each policy is deemed to have contributed. They then allocate the divisible surplus to reflect that contribution.
Although companies publish their dividend interest rate, they are generally not comparable, as the calculation varies from company to company. Some quote gross rates, some quote rates net of investment expenses, while others quote rates net of all expenses. Also, it is important to note that the dividend rate does not equal the yield on the policy, except by happenstance.
The IRS considers dividends on a life insurance policy to be a return of premium, which is good news for policy owners. It means that the dividends remain tax free until they exceed the basis in the policy (generally, the sum of all premiums paid).
Contractually, policy owners can elect several different ways to use their dividends, including 1) receive them in cash, 2) use them to reduce premiums, 3) use them to purchase paid-up additional insurance, and 4) let them accumulate at interest.
While dividends are NOT guaranteed, some of the large mutual companies have long (100 years+) and impressive records of paying dividends. That of course does not mean that they will be able to continue paying them in the future. But since dividends can make up a significant portion of a policy’s total return, it would be prudent to choose a strong company with a significant history of paying dividends. In my opinion, right now, the best mutual companies are Guardian, Mass Mutual, New York Life, and Northwestern Mutual. Of course that is only my opinion, and it in no way suggests that they will be the best (or even around) 5, 10, or 50 years from now.